By Mervyn King, Abacus, RRP £10.99
On the morning of October 23, 2008, a repentant Alan Greenspan, chairman of the U.S. Federal Reserve from 1987 to 2006, admitted he was wrong. Referring to his free market ideology that many blame for engendering the 2008-9 recession, Greenspan told a congressional oversight committee that he had witnessed “the whole intellectual edifice collapse” the preceding summer.
While Greenspan’s contrition may have been satisfying to his critics, it didn’t get to the root of the problem. At least that’s the view of Mervyn King, governor of the Bank of England from 2003-13. According to King’s new book on the crisis, blame for the financial collapse ought not to be ascribed to central bankers, nor, for that matter, to bankers generally. And while sheepish regulators, complex derivatives, and plain greed played a part, these, too, were surface problems. For King, the cause of the collapse is banking “alchemy”: the groundless and ultimately unsustainable belief underpinning the banking system that risk can be magically transformed into safety – that illiquid assets can instantaneously be made liquid (liquidity, King argues, is “the essence of the alchemy of the present system”).
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Bank runs are the most familiar example of alchemy. Runs are essentially the manifestation of a sudden jump in the demand for liquidity (King’s definition of a crisis), but this demand cannot possibly be met because the liquidity is an illusion. Since banks “borrow short and lend long”, they don’t have the cash on hand to meet all of their depositors’ demands. The very possibility of a run, therefore, is an example of the inherent instability of banks.
Bringing about the end of alchemy, King argues, would require a fundamental rethink of banking and finance. He proposes a new model for central banks: rather than thinking of them as a “lender of last resort” – a concept traceable to Walter Bagehot's Lombard Street – he proposes assigning them a new role as “pawnbroker for all seasons ”. As pawnbroker, a central bank is ready to lend at any time, good or bad, so long as the loan is backed by collateral at an appropriate discount or “haircut”. For example, if a portion of a bank’s collateral – a set of safe investments, say – is worth £30,000, the central bank may determine that it’s willing to lend £28,500 – a haircut of 5% (a haircut of 0% would only apply to a totally riskless asset). Once haircuts are applied to every item on a bank’s balance sheet, a bank’s effective liquid assets and liabilities can be roughly calculated. By requiring the former to exceed the latter, alchemy is purged from banking.
King’s book, while illuminating, would benefit from a clearer structure. It’s not always apparent where he is leading his readers, and the broader theme of banking alchemy is only sporadically tied into his arguments. He is also overly fond of the deliberate misquote, the most contrived being his take on Coleridge’s Ancient Mariner: “Debtors, debtors everywhere / and not a loss in sight.”
Yet anyone interested in economic theory is in for a treat. The Arrow-Debreu model, the paradox of thrift, liquidity traps – these are just a few of the complex concepts King deftly introduces to his readers, and his chapter on the role of money in capitalist societies ought to be required reading for students taking an introductory course in macroeconomics. King is at his best, however, on the fundamentals. For those seeking to grasp the most basic structural flaws underlying our global economy, this book is an excellent place to start.